Many financial markets, such as the New York Stock Exchange, American Stock Exchange, Chicago Mercantile Exchange, Tokyo Nikkei Exchange and other financial markets drive the economies of countries throughout the world. These markets measure the movement of investments or financial instruments. Financial instruments are assets or items with value that may be purchased for income, hedging, or capital appreciation.
There are many different types of financial instruments, for example stocks, bonds, futures contracts. Stocks are shares entitling the stockholder to dividends and to other rights of ownership, such as voting rights. A stockholder (a.k.a., a shareholder) has a claim to part of the assets and earnings of the corporation.
Futures contracts are standardized agreements, traded on a futures exchange, to buy or sell a commodity at a specified price at a date in the future. A futures contract specifies the commodity, quality, quantity, delivery date and delivery point or cash settlement. Traditionally, a commodity is a bulk good traded on an exchange, cash or other type of market. Some examples of a commodity include grain, oil, oats, gold, silver and natural gas. More recently, futures contracts have been based on commodities that include foreign currencies, financial instruments and stock indexes. Futures contracts are transferable between parties.
Bundle contracts, also referred to as composite contracts, are exchange-traded agreements to buy or sell a combination of financial instruments, such as a combination of stocks, futures contracts etc. Some composite contracts, including those known as X-funds, traded at the Board of Trade of the City of Chicago, are vehicles to replicate the returns of multiple financial instruments such as futures contracts in a unit, i.e. with one action. In other situations, when a composite contract is bought and/or sold, the actual underlying component contracts are bought and/or sold all at once. The composite contract simplifies trading by permitting the trader to deal with a single instrument having a single set of parameters, for example one price and one quantity, rather than with multiple instruments having different prices and quantities, all at one time. The first type of composite contract is a separate entity with parameters of its own, such as contract size and pricing convention, where the parameters are computed based on the attributes of the underlying component contracts. The attributes of the underlying component contracts used to compute the parameters of the composite contract, taken alone or in combination, may include the price, the quantity, the volatility, the expiration, or other attributes, now or later developed, of the underlying component contracts. The second type of composite commodity has similar parameters, including its own pricing convention, but differs in that a transaction is an expedited surrogate for transactions in the constituent instruments. That is, positions are established or offset in the constituent instruments per the definition of the composite commodity.
As an example of such a composite commodity, we may consider the uses made of a particular futures contract. Eurodollar (ED) futures contracts are futures contracts based on “eurodollars,” which are time deposits denominated in U.S. dollars that are deposited in commercial banks outside the U.S. The Eurodollar futures contract, developed and introduced by The Chicago Mercantile Exchange (“CME”) in 1981, represents an interest rate on a three-month deposit of $1 million. Eurodollar futures contracts are listed according to a regular pattern: quarterly contracts that terminate in March, June, September, and December (“March Quarterly Cycle contracts”) plus additional contracts in the four nearest months not in the March Quarterly Cycle. The March Quarterly Cycle contracts are frequently purchased and sold in equally-weighted groups of four, such as the June 2003, September 2003, December 2003, and March 2004 contracts; these groups are called packs. These four consecutive series of ED futures contracts are quoted on an average net change basis from the previous day's daily settlement price, rounded to one-quarter of a basis point (or tick).
A Eurodollar pack, made up of four consecutive quarterly contracts as discussed above, is designated by a color code, similar to the codes used to designate the underlying ED futures contracts that correspond to its position on a yield curve. Generally nine different packs are traded at any given time, such as red, green, blue, gold, purple, orange, pink, silver and copper, that correspond to Eurodollar future years 2-10.
A combination of packs is referred to as an ED bundle. A Eurodollar futures bundle describes the simultaneous sale or purchase of each one of a series of consecutive Eurodollar packs or Eurodollar futures contracts from one to ten years. (For historical reasons the group of the nearest four contracts in the March Quarterly Cycle is called a bundle, instead of a pack.) The first contract in any bundle is usually the first quarterly contract in the Eurodollar futures strip. Strips of ED futures are simply the coordinated purchase or sale of a series of futures contracts with successive quarterly expiration dates. One exception to the first contract in the bundle being the first quarterly contract in the ED futures strip is the 5-year “forward” bundle, which covers years five through ten of the Eurodollars futures strip. For example, on Mar. 31, 2001, the first contract in a 5-year “forward” bundle would be June 2006 (the 21st contract in the strip), and December 2011 (the 40th contract) the last. Bundles and packs can also be transacted beginning with any contract month in the March Quarterly Cycle, so long as the most deferred contract in the combination is listed for trading. Forty contracts in the March Quarterly Cycle are listed for trading at any given time.
In any bundle, the price is quoted in terms of net change during the current trading session from the previous day's daily settlement price. Specifically, the bundle's price quotation will reflect the simple average of the net price changes of each of the bundle's constituent contracts, rounded to one-quarter of a basis point (or tick).
As an example, consider that all of the nearest 21 contracts (e.g., the June 01 Eurodollar to the June 06 Eurodollar) have enjoyed a three-tick increase in the price since yesterday's settlement; at the same time the prices of each of the next seven contracts (e.g., the September 05 Eurodollar to the March 07 Eurodollar) have posted net gains of four ticks. Under these conditions, the implied fair-value price quotation for a seven-year bundle would be:[{21*+3)+(7*+4)]/28=+3.25 ticks
This example illustrates an important point that unlike Eurodollar futures prices which are generally quoted in increments of one-half basis point, bundle prices are quoted in increments of one-quarter (¼) of a basis point. For Eurodollar futures, the dollar value of a one-basis point move in the futures price is equal to $25. In contrast, for Eurodollar packs and bundles, the DV01 will always be a multiple of $25, $100 in the case of a pack, $200 in the case of a two-year bundle, etc. LIBOR is the rate of interest at which banks offer to lend funds to other banks, in marketable size, in the London Interbank market.
When a trade occurs, the particulars of the transaction are finalized and confirmed by the buyer and seller. For example, when a buyer and seller have agreed upon the price and quantity of a bundle, they must assign mutually agreeable prices to each of the bundle's constituents. In principle, the buyer and seller may set these component prices with one restriction: the price of at least one constituent Eurodollar contract must lay within that contract's trading range for the day (assuming that at least one of the Eurodollar contracts in the bundle has established a trading range). In the vast majority of cases, traders use a computerized system provided by the Exchange and located on the trading floor that automatically assigns individual prices to the contracts within the bundles.
Bundles are simple structures. They are well suited to traders and investors who deal in LIBOR-based floating rate products. Such traders could include investment banks that routinely carry syndication inventories of floating-rate notes, corporate treasuries that issue floating-rate debt, or commercial bankers who wish to hedge the risk exposure entailed in periodic loan-rollover agreements.
Some bundles' most avid followers are those market participants who deal in long-dated Treasury-Eurodollar (“TED”) spreads. A Treasury note or T-note is a marketable fixed-interest rate U.S. government debt security with a maturity greater than 1 year and 10 years or less. A Treasury bill or T-bill is an U.S. government debt security with a maturity less than 1 year. T-bills do not pay a fixed interest rate and they are issued through a competitive bidding process at a discount from par. Such TED spreads trades entail the purchase (or sale) of a treasury security and the simultaneous sale (or purchase) of a strip of Eurodollar futures contracts with a comparable notional term to maturity. A frequently encountered version of these trades comprises a long position in the two-year Treasury note and a short position in some combination of the nearest seven or eight Eurodollar contracts.
Another method by which traders attempt to associate or combine multiple financial instruments is via “synthetic contracts”, another form of composite commodity. A “synthetic contract” is a method of referring to a net position of a portfolio or a portion of a portfolio. Synthetic contracts are not entities in themselves but represent means of creating one kind of commodity through combinations of other commodities. The constituent components of the synthetic contract are traded individually, unlike a composite contract which is associated with its component contracts, as discussed above.
A synthetic futures contract can be created as a combination of a put and a call on the same underlying asset with the same strike price. A synthetic futures in which the put is sold and the call is purchased is bullish, i.e. hoping for a price rise, is referred to as a “synthetic long futures.” A synthetic futures in which the put is purchased and the call is sold is bearish, i.e. hoping for a price fall, is referred to as a “synthetic short futures.” A “synthetic call option” is a combination of a long futures contract and a long put, also referred to as “a synthetic long call.” A synthetic call option comprising a combination of a short futures contract and a short put is also referred to as “a synthetic short call.” A “synthetic option” is a combination of a futures contract and an option, in which one component, either the contract or the option, is bullish and the other component is bearish. A “synthetic put option” is a combination of a short futures contract and a long call, also referred to as a “synthetic long put.” A combination of a long futures contract and a short call is referred to as a “synthetic short put.” Generally, synthetic contracts include any financial instrument that is created using a collection of other assets whose combined features are economically the same as those of the instrument(s) it replicates.
Despite their popularity, such transactions in composite contracts have suffered due to lack of any generic standard. Bond dealerships that promote long-date Treasury-Eurodollar spreads to their clients tend to recommend trades that involve odd numbers of Eurodollar contracts, differing from one point in the Eurodollar strip to the next (“weighted bundle or pack”). The dealers customarily justify their formulations by appealing to proprietary yield-curve models. These models purport to link the futures spot interest rates that are represented by the Eurodollar futures strip to the implied zero-coupon yield curve that is embedded in the prices of the U.S. treasury securities.
Further, due to the characteristics of the underlying financial instruments, such as Eurodollar (ED) futures contracts, economically equivalent composite contracts tend to be unevenly-weighted. In addition, composite contracts, such as ED bundle contracts are not widely available, readily acceptable and they do not provide an interpretable benchmark against which their performance can be judged. Further, the process of constructing a composite contract, such as a weighted ED bundle contract, is long and tedious, which prohibits rapid execution of trades in the component contracts. Synthetic contracts provide a convenient reference system for traders to refer to their portfolios but are limited as to the mix of underlying contracts that can be referred to and do not provide for simplified trading or ease of benchmarking.
Accordingly, there is a need for a system to simplify the creation and trading of composite contracts, increase the availability of such contracts to traders, improve their execution rates and simplify interpretation of their performance.